When planning to reduce your inheritance tax bill, understanding the difference between potentially exempt transfers (PETs) and chargeable lifetime transfers (CLTs) is essential. Making the right choice could save your family thousands in tax.
The easiest way to reduce your estate is to spend it! This can be done either by enjoying the money yourself during your lifetime or gifting it to friends, relatives or charities. But not all gifts are treated equally for tax purposes.
What is a potentially exempt transfer?
A potentially exempt transfer (PET) is a gift you make during your lifetime that could become completely free from inheritance tax. The key word is “potentially” – these gifts start as potentially taxable but become exempt if you survive for seven years after making them.
Potentially exempt transfer examples include:
- Gifts of money to children or grandchildren
- Transferring property to family members
- Giving away valuable possessions or investments
- Setting money aside for a loved one’s future
These gifts aren’t immediately taxable, which makes them an attractive option for inheritance tax planning.
What are chargeable lifetime transfers?
Chargeable lifetime transfers are immediately chargeable to inheritance tax. Such transfers commonly involve payments into a trust which will incur a 20% tax charge on anything over the gift-giver’s nil-rate band (currently £325,000).
Chargeable lifetime transfers examples include:
- Gifts into discretionary trusts
- Transfers to certain types of trust for disabled beneficiaries
- Gifts to companies
- Some transfers involving overseas trusts
Chargeable lifetime transfer vs PET – key differences
The main differences between PETs and CLTs are:
Immediate tax:
- PETs: No immediate tax to pay
- CLTs: 20% tax on amounts over £325,000
After seven years:
- PETs: Become completely tax-free
- CLTs: Original 20% charge stands, but no additional tax
If you die within seven years:
- PETs: May become chargeable at up to 40%
- CLTs: May face additional tax up to 40% (less the 20% already paid)
Potentially exempt transfer 7 year rule
The potentially exempt transfer rules centre on a crucial seven-year period. If you survive for seven years after making a PET, the gift becomes completely exempt from inheritance tax and no longer counts against your nil-rate band.
How the 7 year rule works:
- Years 0-3: Full 40% tax if you die (on amounts over £325,000)
- Year 3-4: 32% tax (20% taper relief)
- Year 4-5: 24% tax (40% taper relief)
- Year 5-6: 16% tax (60% taper relief)
- Year 6-7: 8% tax (80% taper relief)
- After 7 years: No tax at all
Potentially exempt transfer taper relief
Potentially exempt transfer taper relief reduces the inheritance tax rate on PETs if you die between three and seven years after making the gift. This relief only applies to the tax on the gift itself, not to the overall estate.
Important points about taper relief:
- Only applies after three years
- Reduces the tax rate, not the value of the gift
- Only benefits gifts that exceed the nil-rate band
- The gift still uses up nil-rate band for seven years
Who pays tax on potentially exempt transfers?
If inheritance tax becomes due on a potentially exempt transfer, the recipient of the gift is primarily responsible for paying the tax. However, if they cannot pay, the estate becomes liable. This is why it’s important to:
- Keep records of all substantial gifts
- Consider whether recipients could afford potential tax
- Think about life insurance to cover potential tax liabilities
Do I have to declare a potentially exempt transfer?
You don’t need to declare potentially exempt transfers to HMRC when you make them. However, you should:
- Keep accurate records of all gifts
- Note the date and value of each transfer
- Record who received the gift
- Save documentation for seven years
Your executors will need this information if you die within seven years of making the gift.
Inheritance tax and potentially exempt transfers – exemptions and allowances
Gifts to charities and spouses are exempt from inheritance tax. You can gift as much as you like during your lifetime to these recipients and there will be no inheritance tax payable.
Annual exemptions that don’t count as PETs
Beyond these special exemptions, everyone has annual allowances that are immediately free from inheritance tax – they don’t even count as PETs:
£3,000 annual exemption: You can give away £3,000 each tax year without any inheritance tax implications. If you don’t use it all, you can carry forward the unused amount for one year only.
£250 small gifts You can give as many £250 gifts as you like to different people each year. However, you can’t combine this with your annual exemption – so you couldn’t give someone £3,250 using both allowances.
Wedding and civil partnership gifts
- To your children: £5,000
- To your grandchildren: £2,500
- To anyone else: £1,000
Why these exemptions matter: These gifts are immediately exempt – they don’t use up your nil-rate band and won’t be subject to inheritance tax even if you die within seven years. Couples can each use their own allowances, effectively doubling these amounts when giving jointly.
Potentially exempt transfer limit
There’s no upper limit on potentially exempt transfers, but practical considerations apply:
- Gifts over £325,000 risk inheritance tax if you die within seven years
- You must retain enough to maintain your standard of living
- Very large gifts might be challenged if you continue to benefit
Unused annual allowances: You can carry forward one year’s unused annual exemption. For example, if you didn’t make any gifts last year, you could give £6,000 this year. Couples could potentially give £12,000 if both have unused allowances.
Regular gifts from surplus income
Regular gifts from surplus income are completely exempt from inheritance tax – they don’t even count as PETs. To qualify:
- Gifts must be from income, not capital
- They must be regular (monthly, annually, etc.)
- You must maintain your normal standard of living
- Keep records proving the gifts are from surplus income
This exemption has no monetary limit, making it valuable for those with significant surplus income.
Chargeable lifetime transfer after 7 years
Unlike PETs, chargeable lifetime transfers don’t become exempt after seven years. The initial 20% tax always stands. However, if you survive seven years:
- No additional inheritance tax is due on death
- The CLT no longer affects your nil-rate band
- The trust continues under its original terms
This certainty can make CLTs attractive despite the upfront tax cost.
Potentially exempt transfers and chargeable lifetime transfers – making the choice
Choosing between PETs and CLTs depends on your circumstances:
Consider PETs when:
- You’re confident of surviving seven years
- You want to make outright gifts
- You prefer to avoid immediate tax
- The recipients are responsible adults
Consider CLTs when:
- You need to retain some control via trustees
- Beneficiaries need protection
- You’re planning for multiple generations
- The immediate 20% tax is acceptable
Get expert advice on lifetime transfers
Understanding potentially exempt transfers and chargeable lifetime transfers is complex but getting it right could save significant inheritance tax. Our experienced private client team can help you choose the most appropriate strategy for your circumstances.
We can advise on:
- Whether PETs or CLTs suit your situation
- Maximising available exemptions and reliefs
- Record-keeping requirements
- Life insurance to cover potential tax
- Trust arrangements for CLTs
To learn more about how PETs and CLTs affect you, get in touch with Annelise Tyler by email annelise.tyler@wellerslawgroup.com or by phone 01732 446374 today.